The Acid Test For Active
Rise and shine.
It was the Fundsmith1 annual shareholder meeting last week, and Terry Smith once again took the opportunity to claim that passive investing has “distorted” the stock market.
His argument is essentially that as index funds are price agnostic the biggest stocks attract more flows and get even bigger - by virtue of nothing else other than already being the biggest stocks. That the high concentration of the market in the biggest tech companies is based on nothing more than their pre-existing size, and certainly not based on their fundamentals2.
Which is frustrating for a stock picking manager like Smith, who seeks outperformance by finding “good” companies who are generally of a better quality than the overall market.
Now, at the outset I should declare an interest. If you were to put a gun to my head and tell me to personally invest in an “active” fund, it would probably look a lot like Fundsmith.
While I disagree that this kind of strategy can add value, consistently and reliably over time - I do like his clear approach, and objective of making as few decisions as possible. Any time I have met him I have always found him to be approachable, and straight talking too - which is a rare quality in fund management land.
Smith’s argument is a common cry from the active management community. It has been pretty tough to beat the index, because most stocks have underperformed the index. And on the face of it they have a point.
But if this is the claim, then surely the opposite is true as well? When market returns broaden away from a handful of technology companies, then active strategies will have their moment in the sun.
Well, since last summer returns have been less concentrated.
Over the past couple of months this trend has accelerated and there has been a ‘yuge rotation under the bonnet of the market from the biggest stocks into almost everything else that isn’t a technology company.
Investors are prioritising companies which own tangible assets and revenue flows, rather than hopes and dreams. The market seems to want “bricks over bytes” as the inimitable Mr Jonathan Raymond Esq. has coined it.
As most stocks are now outperforming the index, you would think this is an ideal environment for Mr or Mrs stock picker. This is exactly the kind of market they have been craving.
Or put another, rather less generous way, it is time to put up or shut up.
The primary reason for this, is that most active funds have underperformed their benchmark index - investors in these funds have been paying more in fees, for worse outcomes. Which, isn’t ideal.
Personally, I think a healthy market needs a thriving active management sector. Not least to ensure healthy price discovery of individual securities.
But I’m not buying that index investing creates distorted markets, “passive strategies” are price takers not price makers after all.
And if this rotation from the biggest stocks into everything else continues and active managers continue to underperform the index - it would feel to me like the final nail in the coffin for active management as an asset class.
Active managers are getting exactly what they wanted. If they can’t outperform here, then I don’t know what to say. It might be time to hang it up chief.
Have a great weekend.
Past performance is not indicative of future returns. None of the above is intended to represent advice to any individual. If you have any queries regarding your specific situation, please consult with a regulated financial adviser.
Fundsmith Equity is one of the largest retail investment funds in the UK, with £14.5 billion of assets under management, managed by one of the UK’s most prominent fund managers - Terry Smith. It holds a concentrated portfolio of global stocks.
Thanks for the shout out David! Great piece as always